The Hidden Costs of Cutting the Mortgage Deduction
Life + Money

The Hidden Costs of Cutting the Mortgage Deduction

iStockphoto/The Fiscal Times

If the mortgage deduction lands on the budget chopping block, it could end up killing the big house with the three-car garage.

A common thread running through nearly every deficit reduction plan is the elimination of hundreds of tax breaks, including the mortgage interest deduction. The housing deduction plays a crucial role in the finances of many families and changing it could have unexpected ripple effects throughout the economy. Yet the mortgage deduction has evolved into the second-most expensive tax subsidy in the behemoth code, costing the federal government $99.8 billion in missed revenues in fiscal 2011 alone. 

Although none of the plans eliminate the mortgage deduction completely, the debate over the consequences of such a change is fierce. The real-estate industry has says eliminating or even decreasing the deduction will have disastrous consequences for the already battered housing market. Homebuilding and real estate groups, which spent more than $68 million on lobbying last year, are aggressively fighting the possibility of cutting the tax break.

“From a macro-economic perspective, this is just what the economy doesn’t need right now,” says Robert Dietz, Assistant Vice President of Tax and Policy Issues at the National Association of Homebuilders.  “The kid who’s living on the couch, the recent college graduate who’s moved in with his parents, the struggling family who’s renting.  If you restrain that potential housing demand by increasing people’s costs then you’re going to exacerbate the inventory problem, the supply problem, and increase downward pressure on housing prices.” 

But a diverse group of economists say cutting the deduction would have only a short-term negative effect on the housing market, and would have little or no affect on lower-income taxpayers from buying homes. That’s partly because only about two-thirds of the nation’s 52 million homeowners with a mortgage now take the deduction, according to IRS data.

The fact that many homeowners don’t or can’t claim the mortgage deduction limits the damage of limiting or doing away with it, according to Mark Dotzour, Chief Economist and Director of Research at the Real Estate Center at Texas A&M University.  And many people have strong emotional incentives for buying a home rather than renting, Dotzour says. “People typically buy a home because they started a family, had a baby and need a bigger place; just got a promotion and want a nicer place; or just got a divorce and need a smaller place,” he says. “All those things that create standard demand for houses year-in and year-out — tax credits don’t have anything to do with them, and people will buy homes whether the credit is there or not.”

Some parts of the housing market may suffer from a change more than others. The higher the income bracket a taxpayer is in, the larger share of the tab the government picks up. For a taxpayer in the 35 percent bracket (earning $379,150 and above), the government will pay 35 percent of the mortgage interest payment. For a taxpayer in the 15 percent bracket (earning up to $34,000), the government picks up 15 percent.  Since the value is highest for higher-income households (who pay the vast majority of all taxes collected by the federal government), ending or limiting the deduction would hurt them the most. By extension, it might also hurt real-estate values in areas of the country where home prices are higher, including cities, according to a number of economists who spoke with The Fiscal Times.

Smaller Homes, Price Declines
Jean Bell, a realtor based in Philadelphia’s affluent Main Line suburbs, says she thinks curbing the deduction would hurt her business. Bell, who sells mostly properties priced between $1 and $4 million, says though many of her clients can often afford to pay with cash, they will finance their homes to optimize their returns with the deduction. “In the current economy, I can see a lot of people I deal with choosing not to buy, saying, ‘Well, I’ll just invest my couple million dollars and use the interest to pay rent’.” She is already seeing demand for high-end rentals increase.

Any change in the deduction could also send shock waves through the new home market. “Will the breakdown of the deduction hurt us? Sure,” says Ken Doocy, vice president of Jack Watson Homes in Georgetown, Texas. The company builds properties mostly in the $300,000 to $500,000 range. “Will some people say, ‘I’m not going to buy a house because I can’t write off 30 percent of my interest payment’? Maybe, but once rents go up because demand for rental properties is up, things will come out right,” he adds.

Like Doocy, some experts say any negative effect is likely to be short-term. “It probably does make sense to remove the mortgage tax deduction, which really does act as a subsidy for wealthier households—especially with the fiscal situation being what it is,” said Celia Chen, a senior director at Moody’s Analytics. “There’s going to be a period when lack of the deduction is going to hurt home sales, but in the long run it’s not going to have a big impact on the housing market because prices will adapt downward to reflect that you can’t get the deduction, and that will lead demand to pick up again.”

If prices decline across the board, that make already jittery consumers even less likely to spend. But the change may be a good thing in the long run. It could benefit people who currently don’t own homes, says Roberton Williams, a senior fellow at the Tax Policy Center. “The incentives will be for new housing to be smaller, because that’s where demand will be,” he said. “Less demand for mega-mansions and more ordinary, modest-sized houses built,” he predicts.  Additionally, Williams points to the comparable homeownership rates in other countries with similar housing markets and demographics to the US, such as Australia and Canada that lack a mortgage interest tax incentive.

“I think there’s a lot of wiggle room … to be able to politically deal with the housing market lobby here and still not destroy housing market demand,” said Diane Swonk, Chief Economist of Mesirow Financial, a financial services firm.  “Why not do it when demand is weak and affordability is high, anyways?” 

One potential roadblock for Congress could be a political backlash from voters, Swonk added—a hypothesis a recent string of polling data confirms.  An April Wall Street Journal/NBC News poll found that 61 percent of respondents were opposed to eliminating the home mortgage interest deduction.  A March poll from RealtyTrac found that a whopping 83.6 percent of respondents wanted the deduction left completely alone. 

Because all of the proposals differ in exactly how they would treat the deduction, it may simply be too early to judge the effect of any changes. Under current law, taxpayers who itemize can deduct interest on mortgage debt totaling $1 million and up to $100,000 on lines of credit and home-equity loans for principle on a second home. The Fiscal Commission’s proposal would replace the mortgage deduction with a tax credit worth 12 percent of the interest paid on a home, and would cap the size of mortgages eligible for the subsidy at $500,000 instead of the current $1.1 million. It would completely exempt second homes from mortgage interest deductibility.  President Obama, in his most recent budget proposal, proscribed that taxpayers in the 33 percent and 35 percent brackets only be allowed to deduct their interest payments at the 28 percent rate. 

The most damaging aspect of any change in the interest deduction could be psychological, according Barbara Corcoran, founder of the New York-based Corcoran Group.  “In the housing market, perception always weighs in much more than fact,” she says.  “Would-be buyers already lack confidence in the housing market and don’t need one more reason NOT to buy.” 

Related Links:
Slash Mortgage Deductions for the Rich? Fat Chance (CNNMoney)
Raise Taxes but Not Rates (New York Times)
Eliminating the Mortgage Deduction Would Threaten the Recovery (Washington Post)